Summary
- Harrow entered an opaque market filled with middle men and dissatisfied ophthalmologists. Harrow understands their customers, solves their pain points, and has earned their trust. This is a deep moat.
- The company was built by founder/CEO Mark Baum from zero to a dominant position in its niche in just 9 years. Very impressive.
- Harrow now controls a unique distribution channel. As new products are created or acquired, Harrow can simply plug them into the channel and generate huge margins.
- A short report on Harrow Health published February 22, 2023, made 5 bold claims about the company. The short report is demonstrably misleading on all 5 claims.
- The stock is down 20% from its recent high, likely the result of shorts first building their position, followed by the market's reaction to the report itself.
Harrow Health (HROW) is a dominant company in the very small ophthalmology pharmacy niche. The legacy business is pharmacy compounding, and the market just seems to hate this business with a passion. It's nothing in particular about HROW, just the whole space. There's a lot to complain about, with patients and physicians feeling poorly served by a confusing and inefficient network of middle men feeding on an opaque system. Harrow was built in response to this, by listening to customers, as an efficient, transparent, and vertically integrated company with production, distribution, and marketing all under one roof. Their customers love them, and NPS scores are high. I previously covered HROW in this article , so check it out if you want to.
HROW is growing like crazy, from no products or customers in 2014, to the largest U.S. ophthalmic focused pharmacy today. Major new product launches are underway, and revenue, EBITDA, and FCF should continue to absolutely soar as a result. The company is expanding into a new business line of branded pharmaceuticals through M&A, including the huge "Fab 5" acquisition I discuss in depth below. This will be transformative for the company. They can just take their platform - they have a huge customer base - and sell into that base as they acquire products they think will serve their customers well. The synergies of adding products to HROW's existing best-in-class distribution footprint is compelling, and management's enthusiasm is palpable.
In addition to the rapidly growing legacy business, the new product launches, and the massive acquisition, the company also has two "hidden assets" that by themselves may be worth more than the current market cap.
I'll get into all of that below, but first I note that this morning - it's February 22 as I write this - HROW was on the receiving end of a short report from Bonitas Research. I will begin there.
The Bonitas Research Short Report
The report made 6 bold claims which, for some reason, are numbered 1 through 5. I will address the last of them - the one with no number - first. It is:
Harrow burns cash from operations and relies on external financing for survival.
This is factually wrong, as anyone can easily verify by looking at the Q3 2022 10Q , which shows positive FCF YTD in 2022. It's not a huge number, just $3.7M. 2023 will be higher, and then I think the numbers will start to get pretty huge. I have them at over $6 a share in 2025, for example. But even in 2022, they are not burning cash, they are generating cash. So this "claim with no number" is factually wrong.
The short report is not off to a good start. Being unable to read a cash flow statement is not a good look.
Here are the other items, that did get numbers:
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1) U.S. Department of Justice ("DOJ") Investigation into Dexycu sales practices: In August 2022, Eyepoint received a DOJ subpoena seeking the production of documents related to sales, marketing, and promotional practices related to Dexycu. Harrow did not disclose this subpoena to investors despite being the responsible party for Dexycu sales, marketing, and promotional practices... We think Harrow did not disclose to investors the existence of a DOJ investigation because it would have compromised Harrow's ability to raise capital.
Emphasis mine. Well, this is an interesting claim, and if getting to the truth of it were important, one could imagine one might call the company and ask them. And if one had done that, they would have said that no, there is no DOJ subpoena into HROW. Here's what the company emailed to investors in response:
Regarding Harrow being the subject of a DOJ investigation, Harrow has never received a DOJ subpoena and has no knowledge of being the subject of such an investigation.
So the short report is now 0 for 2. The first because they, I don't know, misread the cash flow statement? And the second because they didn't fact check. But wait, it gets worse.
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2) Harrow has not disclosed to investors recent FDA actions: In June 2022, Harrow received a FDA Warning Letter for false and misleading marketing claims. In August 2022 Harrow received a FDA Form 483 inspection report which cited unsanitary conditions and drug quality issues. Harrow did not disclose any such actions to investors. A few months later following these actions, the company issued a nationwide recall with the FDA.
I can personally vouch for the fact that I am an investor, and I did know about these FDA actions, and discussed it with management. The FDA regularly inspects facilities and asks for corrections and improvements. It's normal, and no big deal. Here is HROW's response:
Harrow... calls attention to the November 28, 2022, renewal registration, by the FDA, of Harrow's New Jersey facility.
So, whatever might have happened in August of 2022, by November 2022 relations with the FDA were apparently just fine.
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3) Acquired Novartis drugs show abysmal growth: We reviewed Rx unit growth reported for Harrow's nine licensed drugs from Novartis. Despite Harrow's claim that sales of the FDA-approved Novartis drugs are an exciting growth opportunity, our research showed that these drugs have suffered from a massive decline in Rx unit fulfillments due to competition from alternative branded and generic drugs. To us, this suggests that Harrow licensed unpopular legacy Novartis drugs with little Rx unit count growth.
So... the "big reveal" here is that the recently acquired products from Novartis are not growing. I mean, everyone familiar with HROW knows that. That's the whole thesis behind buying them! Novartis is spending no effort or money to market these drugs, and HROW has huge distribution in their niche with a ramped up sales force specifically to market the Fab 5 - along with IHEEZO (I'll get to that) - and expects to ramp sales up. Right or wrong, that's the whole point of the acquisition! So pretending that it's a revelation that on Novartis' watch that these drugs were underperforming, that's either disingenuous, or indicative of someone just not familiar with the company.
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4) Iheezo does not look like a beacon of growth: Despite Harrow's bullish comments about Iheezo, we expect the first branded ocular anesthetic in 14 years to have a tough time becoming a successful growth story. Iheezo's compound was initially approved by the FDA in 1955 (~68 years ago) and faces established competition in a very mature category that shows little Rx unit count growth.
Well, at least this time it's an opinion. HROW management says IHEEZO sales will eclipse the rest of the legacy company's combined sales within 2 years of launch. Investors can agree or disagree with that. But I certainly do agree with it. Part of the reason for this is that HROW dominates the Ophthalmology Pharmacy space, and this puts them in a position to know what their customers want. And it puts them in a great position to sell to them, too. HROW is involved in 20% of cataract surgeries today, and growing fast. IHEEZO would be an epic home run with far less than a 20% share. A 10% share is enough for a $500M drug, for a company that in 2022 will have roughly $100M of revenue. So that's one reason.
And the second is that IHEEZO allows for pain free cataract surgery without resorting to opioids. Zero patients in the clinical trial required opioid rescue. None. That's a huge focus in medicine today, and as a result IHEEZO was granted early, accelerated FDA approval and has already been awarded a J code . So yeah, it does look like a "Beacon of Growth". It's patented through 2037, so no competition for a while. I don't see any answers to this in the short report.
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5) Off balance sheet drug development entities filled with losses: In recent years, Harrow made five off balance sheet investments into former Harrow subsidiary spin-offs (the "Fab Five") generating significant losses for Harrow shareholders. One of Harrow's investments, Surface Ophthalics ("Surface"), was written down to zero as of FYE 2021. Another Harrow investment, Melt Pharmaceuticals ("Melt") filed and withdrew its S-1, implying limited interest since September 2022. These investments follow a similar pattern whereby Harrow insiders receive personal stock incentives in, employment and consulting fees from, Harrow's former subsidiaries to enrich themselves.
Yes, HROW owns equity in off balance sheet entities, Surface Ophthalmics and Melt Pharmaceuticals. These companies are developing drugs, which does cost money, and they have no revenue yet. Both were spun out of HROW because CEO Mark Baum did not want to burden HROW shareholders with the expense of developing these drugs. Instead, all the expenses are paid for by venture capital, leaving HROW in possession of a 20% equity stake and a 4% royalty in Surface, and a 46% equity stake and 5% royalty in Melt. Both Surface and Melt have had superb clinical trial results, and these drugs are likely to be worth a ton of money to HROW, and to the venture capital that's currently paying to develop them. But, importantly, there is no possible downside to HROW. Worst case, the VC have thrown their money away. Best case - and by far the most likely case - Melt and Surface are worth a ton. But there's just no way owning a "free option hidden asset" in two companies belongs in a short report. It's absurd.
As an aside, the short report also erroneously calls out the off balance sheet subsidiaries as the "Fab Five". These are not the Fab 5 at HROW. As all HROW investors know , the term is used to refer to the five drugs acquired from Novartis. I don't want to make too big of a deal about this, but I do think it shows the level of familiarity of the short sellers with the company. It's another basic fact that everyone else knows.
Ok, short report aside, let's talk about HROW.
Harrow is a growth business
Let's start by showing the track record for HROW and CEO Mark Baum. In 2014 the company had no products and no revenue. Here's what happened since then, revenue and EBITDA since 2015, all numbers are in .
Year | 2015 | 2016 | 2017 | 2018 | 2019 | 2020 | 2021 | YTD 2022 |
Revenue | 9.7 | 19.9 | 26.8 | 41.4 | 51.2 | 48.9 | 72.5 | 68.3 |
EBITDA | (10) | (10) | (7) | 0 | 4.6 | 5.7 | 19.5 | 11.9 |
Note that the only year revenue didn't ramp way up was 2020, the result of the pandemic. Also, EBITDA is not increasing in 2022 along with revenue because the company is ramping SG&A expenses way up - by $14.4 million so far in 2022 - to support the launch of the new branded pharmaceuticals, which is scheduled to begin in March of 2023. Since the products have not launched yet, SG&A is way up with zero associated revenue. But EBITDA would be way up - more than 30% over the first nine months of 2021 - if the SG&A growth rate had simply matched the revenue growth rate. The market is clearly missing this.
The "Fab 5" acquisition
On December 14 2022 HROW announced a transformative acquisition , in which they would acquire 5 new drugs for as much as $185M. There is a roadshow slide deck you can check out, if you want to. HROW is paying $140M up front, with a $45M milestone payment to be paid later if certain conditions are met. Funding includes cash on hand, a $25M share issuance, and $100M of new 2027 debt at just over 11% interest.
The market's response to this announcement was quite positive, driving the stock price to a new all time high. But not anywhere near as positive as it should have been. It's easy to see why the market is confused, because the full power of the deal is understated in filings so far. Here's how HROW described the impact of the acquisition in the press release
Assuming this transaction closes during the first quarter of 2023, Harrow expects 2023 net revenues to be between $135 million and $143 million and adjusted EBITDA to be between $44 million and $50 million, with both net revenues and adjusted EBITDA ramping up during 2024 and beyond
and from the prospectus :
Management estimates that during the twelve months ended September 30, 2022, the Products acquired in the Acquisition with near immediate commercial availability (Ilevro, Nevanac, Vigamox and Maxidex) would have generated Adjusted EBITDA of $33.3 million...
A first impression might lead one to think that HROW is spending $185M to buy $33.3M of EBITDA, and perhaps $50M or revenue. That is not quite right.
There's a lot to unpack here, and I doubt the market understands most of it. First, just a technical point. They acquired 5 products, but only 4 of them have any TTM EBITDA. The fifth, Triesence, was not available during the past 12 months, and produced no EBITDA. The $45M milestone payment is for Treisence, once it's back in production and available. Adjusting for this, HROW is actually paying $140M for $33.3M of TTM EBITDA, and then another $45M for Triesence at some point in the future. Actual EBITDA likely will be much higher than this once the company is able to support the growth. From the roadshow investor presentation:
within the past 5 years, aggregate gross sales of the Fab 5 products exceeded $200M per year... There is ongoing strong clinical need for the Fab 5 products, with demographic changes expected to further increase target patient populations... As a result of several factors, including the abandonment of marketing and sales detailing, sales of the Fab 5 products have declined...
HROW's thesis is that these drugs have tremendous potential, and that HROW will realize this. The company didn't overpay even if the drugs never turn around. But any progress from the current ~$50M level of sales - any at all -toward the historical $200M peak would be a huge win. Remember, HROW in 2022 has sales of $100M. The Fab 5 could easily be a lot bigger than the legacy company.
New product launches: Fortisite and Atropine
The company called out two major developments on the second quarter earnings call, Fortisite and Atropine .
Fortisite
Fortisite is a shelf stable fortified antibiotics solution administered as eye drops to treat eye infections. Antibiotics are prescribed for roughly 1 million eye infections each year in the US. The legacy compounds are not shelf stable, however, so doctors cannot store them at the office. Instead, the product has to be rush ordered and delivered after a day or two, delaying treatment and potentially putting the patient's sight at risk. With Fortisite, a doctor can keep some in a refrigerator at the office and treat patients immediately. Here's what Baum had to say on the Q2 2022 call :
fortified antibiotics are used all over the country to treat sight threatening conditions. And unfortunately, there is no FDA approved product... formulations are compounded at local pharmacies... There is no way for an eye care professional to actually stock the medication... when a patient presents with a sight threatening condition... eyecare professionals want to have access right then and there...
the formulation that we've been able to create... will allow an eye care professional for the first time to have in their office a medication, a fortified antibiotic product, to prescribe to these patients and make sure that at their office at the time the patient presents, they will be able to know that that medication is on the patient's eye and that they are being treated for... [a] potentially sight threatening condition... No one else has it and we're going to bring it to the market.
The market opportunity for Fortisite is over $200 million annually, with a price point over $200 per treatment, with more than 90% gross margins. While it's not clear what share HROW will earn, they have a genuinely superior product, and might therefore get some real traction. Given that HROW's revenue in 2022 is roughly $90 million, it could be a needle mover.
Atropine
The second new launch, Atropine , is a product in which HROW has no special product advantages. Atropine is used to treat myopia and presbyopia, and is expected to have a huge end market, estimated at $4.5 billion in 2028 . While HROW is able to sell Atropine today as a compounded product, the economics will most likely be captured by branded, FDA approved drugs. There is a major effort underway to develop these, and HROW is not a contender.
However, HROW is advantaged as the largest distributor in its tiny niche, and owns the Atropine.com domain name. The company believes Atropine could prove to be a needle mover, perhaps on par with Fortisite. HROW's role would be as a compelling distribution partner for those who ultimately own the patents. I do not have insight into this other than to say it's plausible, and even a tiny fraction of $4.5 billion will make a big impact on tiny HROW.
IHEEZO
IHEEZO is a new, FDA approved drug owned by HROW, and represents a massive opportunity. CEO Mark Baum said in his Q1 2022 letter to shareholders that:
within 24 months of FDA-approval for [IHEEZO], revenue from BPPs should eclipse revenues from CPPs... Further, we anticipate that our gross margins from BPPs will be larger than those from our CPP business, thereby causing our overall gross margins to begin to float higher.
I have spoken with the company and they were clear that this was not because the legacy CPP business would be shrinking. It would be growing rapidly, but IHEEZO would, by itself, represent more revenue within 24 months than the growing legacy business. IHEEZO was approved in October 2022 , will launch in March of 2023, and is expected to rapidly ramp starting in Q3 2023.
That's at least $125 million of annualized revenue by late 2024, but that's really just the tip of the iceberg. IHEEZO is a non-opioid pain medication, which means it may be eligible for Medicare pass-through status through its patent expiration in 2037. If they get that extended pass-through status, they will have plenty of time to ramp IHEEZO up to its full potential. CEO Baum addressed this on the February 24, 2022 Aegis call :
Without question [IHEEZO] is a huge opportunity for us. When you talk about 12.5 million annual procedures in a market that we have a strong foothold in... even 4.5 million cataract surgeries... we make drug currently for about one out of every 5, so a 20% market share within that cataract surgery market... and you take that unit opportunity and you multiply by... $600 dollar a unit range... you can come up with a multi billion dollar annual revenue opportunity... that would not be possible... were it not for the core ImprimisRx business, because those customers that order from us month in and month out, those are the customers that we're going to bring [IHEEZO] to... once [IHEEZO] is launched we're going to see revenue more than double, rapidly, as the result of that launch alone.
So how big can IHEEZO get for Harrow? Just using their current 20% share of cataracts, at the $600 price target, is $540 million. This would lead to EPS in excess of $10 a share just from IHEEZO. If things go really, really well then one might imagine a rapidly growing Harrow might have e.g. a 30% share of the full 12.5 million addressable market (including the 8 million intravitreal injections), an incredible $2.25 billion revenue opportunity.
Caution on IHEEZO
While the IHEEZO opportunity is truly very large, and they are going to capture some great economics through 2025, the only way for them to get full value from it is if Medicare grants them extended "pass-through status" through the 2037 patent expiration. It will take time for IHEEZO to ramp up to a $1 billion or more drug, perhaps taking until the end of this decade. HROW may only capture the first 3 years of this potential blockbuster, enough to generate perhaps $10 a share of cash. Not bad. If Medicare grants extended pass-through, though, then the gravy train will roll on and could become truly epic. If not, then IHEEZO may become just another ordinary product for them in 2026.
Hidden assets: Melt and surface
Harrow has made a regular habit of starting businesses opportunistically that don't necessarily fit into their core mission. Harrow deconsolidates these and arranges for outside financing and independent leadership, but retains equity ownership and royalty rights. A case can be made that these hidden assets may be worth more than Harrow's current market cap. They are:
- Surface Ophthalmics. Harrow owns 20% of the equity and retains a 4% royalty on all 3 of Surface's chronic dry eye drug candidates. There's been a very positive outcome in phase 2 trials at Surface, which has revenue potential in the hundreds of millions of dollars. While Harrow is probably not the ideal commercialization partner for these drugs, if one of Surface's drugs is approved the equity will be monetized for many tens of millions of dollars, while the royalty might be $10 million a year, with no offsetting expenses.
- Melt Pharmaceuticals. Melt has a pivotal phase two program underway with an exciting non-IV non-opioid sedation and analgesia medication. Its addressable market is ~100 million annual procedures in the U.S., with potential to be a $1 billion revenue drug, or more, if things go well. Harrow is not the right commercialization partner for Melt, but owns a 46% equity stake and 5% royalty rights, and a $13.5 million note. It's not hard to imagine an eventual royalty stream from Melt of $1 per share or more, plus monetization of the equity and repayment of the note.
Valuation
I estimate $400M of revenue for HROW in 2025, with 90% gross margins. The legacy compounding business is growing fast, perhaps $125M for that alone. And then Fortisite and Atropine, another $35M. The Fab 5 at $100M seems conservative, and then IHEEZO at $150M. Again, likely conservative. That adds up to $410M. Again, in 2022 revenue will be roughly $100M. This is big growth. And SG&A is not expected to rise rapidly from its current level $60M annualized run rate. They have already ramped up the sales force, ahead of time. EBITDA close to $300M is likely, and after deducting interest expense and taxing at 25%, FCF is likely to exceed $200M that year. There are 30M shares, so that's ~$6.50 a share.
If we put a 10 multiple on this, the stock is at $65. A 15 multiple, and the stock is triple digits. And this gives no value at all to the hidden assets, Melt and Surface. I think these will both work out really well. While I expect no revenue from either of them in 2025, the potential for $1 to $1.50 a share in annual royalties alone, plus the equity stakes, likely make the hidden assets by themselves worth more than the current share price of about $16.50 as I write this.
Put it all together and my price target for 2025 is a nice, round $100.
Risks to the thesis
The risk to the thesis is that something will go wrong with both the execution on the Fab 5 acquisition and with IHEEZO. The thesis remains quite robust if only one of them were to prove to be a complete failure. For example, if the Fab 5 were to head to zero revenue in 2025, I would have to reduce my FCF/share estimate to $4, while if IHEEZO were, for some reason, to be a total zero, I would reduce FCF to about $3 a share. If both were to somehow wind up being worthless - extremely unlikely in my view - FCF would be only $1/share, and the company would have to aggressively cut SG&A, use all FCF for debt reduction, and hope the Melt and Surface subsidiaries rescue them. If this were to happen, the stock price would likely be down from the current $16.50 price.
Conclusion
HROW is a fast growing business with earnings potential above $6 a share as soon as 2025. The stock was recently subject to a short report, and the price declined as a result of this. There is nothing of merit in the report in my view.
The company is run by its obsessive and entrepreneurial founder, Mark Baum, who built this best of breed business from nothing in only 8 years. Harrow possesses a deep moat in its niche ophthalmic market, because it understands its customer base and has earned their trust. For this reason the new products are likely to succeed, and if they do then the company is trading at less than 3 times forward earnings. The upside from the new products might be far more than the base case, and it's not out of the question that Harrow stock might be up tenfold or more in a few years. Harrow also possesses hidden assets that may generate equity monetization and royalty streams worth more than the entire market cap of the company today.
At less than 3x 2025 earnings, the price is absurd, and the stock should be bought.
For further details see:
Buy Harrow Health: Correcting A Shortsighted View